Banking

Examiner: Repo 105 helped disguise Lehman's ailing health

SimonKennedy

LONDON (MarketWatch) -- An accounting maneuver known as "Repo 105" was a "drug" that helped maintain a veneer of health on Lehman Brothers' crumbling balance sheet in the months running up to its bankruptcy, a report from a court-appointed examiner shows.

The firm began using the Repo 105 as far back as 2001, but its use picked up sharply toward the end of 2007, even in the face of concern from some staff, as banks worldwide came under more and more pressure to cut their leverage.

Responding to an April 2008 email asking if he was familiar with the transaction, Bart McDade, the firm's then-head of equities and subsequently chief operating officer, replied: "I am very aware... it is another drug we r on," according to the report by examiner Anton Valukas.

The report, which runs to 2,200 pages, said former top officers including ex-CEO Dick Fuld and Chief Financial Officers Chris O'Meara, Erin Callan and Ian Lowitt could face legal claims for negligence of breach of duty.

Auditor Ernst & Young could also potentially face a professional malpractice claim for not challenging Lehman's non-disclosure of the off-balance sheet transactions, the report said. See full story on the Lehman report.

At its peak in the second quarter of 2008, Lehman used Repo 105 to effectively move around $50 billion of assets off its balance sheet, according to the report.

An ordinary sales and repurchase agreement -- or repo -- involves the transfer of assets to another party in exchange for cash, while agreeing to repay the money and take back the assets at a later date.

It's essentially a type of secured loan and is booked that way in the accounts -- leading to an increase in both assets and liabilities.

But Lehman's trick was to use a clause in the accounting rules to classify the deal as a sale, even though it was still obliged to repurchase the assets at a later date. That meant the assets disappeared from the balance sheet, and it could use the cash it received to temporarily pay down other liabilities.

The net result was therefore to shrink both sides of the balance sheet. That led to a sharp reduction in the reported leverage, which was crucial for maintaining the group's credit rating as rating agencies and investors began to focus more on leverage and demanded lower risk.

Window dressing

One of the factors that allowed Lehman to classify the transaction as a sale was that it handed over assets worth at least 105% of the cash it received -- hence the name Repo 105.

Emails cited by the report describe the transactions as "window dressing" and an "accounting gimmick."

Other correspondence showed how some divisions ramped up usage just before the end of a quarter to meet balance-sheet targets.

"We have a desperate situation and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it," the head of the liquid markets group in the firm's fixed-income division wrote shortly before the end of the first quarter of 2008.

At the end of that quarter, Lehman reported a net leverage ratio of 15.4, but Valukas calculates it would have been 17.3 if it weren't for Repo 105.

Once the new accounting period had started, and the Repo 105 transaction had matured, Lehman borrowed money to repurchase the assets, sending its leverage ratio back up again.

Lehman had to overcome one final hurdle before it could book the deals as a sale -- it had to get a legal opinion that the deal was a "true sale."

"The problem was that Lehman was unable to obtain a true sale opinion from a U.S. lawyer," Valukas said in his report.

Instead all the deals were channeled through the firm's London operations, where it was able to get a true sale opinion from law firm Linklaters under U.K. law.

In a statement, Linklaters said Friday that Valukas' report doesn't suggest the legal opinion it gave under English law was wrong or improper.

"We have reviewed the opinions and are not aware of any facts or circumstances which would justify any criticism," the law firm said.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.